Fiscal deficit, CAD to act as party spoilers

Indian markets are trading close to their lifetime high posted in January 2008. However, unlike the past, the present mood looks like the first leg of a bull-run, rather than the last.

Consdier this: Retail or small investors have been exiting the market every time its goes up. This time, there is hardly anybody left in the market, whether those investing directly in stocks or those investing via mutual funds. Like in all bull markets, they may return when stock prices touch dizzying heights, just before another collapse.

Other factors also favour Indian stock markets at this moment. The government is taking tough steps to tackle the growing oil subsidy, while it has opened retail, aviation and insurance sectors to more foreign direct investment. Meanwhile, inflation is cooling off, the interest rate cycle is turning, and the economy may have bottomed out.

While this sets the pitch for the next big bull run, similar to the one witnessed from September 2004 to January 2008 (the Sensex went up from 5,192 all the way to 20,869 in that period), there are three-four key concerns that can hamper a smooth upward climb.

So, what are the major risks?

Analysts at Kotak Institutional Equities led by Sanjeev Prasad have pinpointed three major challenges viz., balance of payment (BOP), fiscal deficit and non-performing loans (NPL) and said an evasive attitude towards the challenges and ambitious approach to addressing them was unlikely to address the problems, but only postpone them.

Experts also caution on other risks, such as early general elections and spike in oil prices. The possibility of a populist budget also cannot be ruled out entirely, given this will be the last budget by this government ahead of the 2014 elections.

“In our view, India stands at an important juncture in its journey. The way it manages the macroeconomic challenges and finds appropriate solutions (or not) will shape its destiny (and investment opportunities for investors). This is not an intellectual debate as it will affect India’s macroeconomic outcomes and growth for the next several years,” Kotak analysts wrote, in a report dated January 14.

On the BOP problem, Kotak said: “We are worried about India’s rising trade deficit and CAD (current account deficit) and India’s decision to increase overseas borrowing limit for the government and companies. There is yet little focus on enhancing India’s competitiveness to increase exports in order to reduce a burgeoning CAD. India’s external debt has risen rapidly to $365 billion against $172 billion at end-FY07. Indian companies have been swapping domestic loans for foreign debt, attracted by lower borrowing cost. This increases the risks to India’s BOP position from any unexpected depreciation in the currency or change in view about India and its prospects.”

According to Aditya Narain, strategist at Citigroup, the rising market has raised economic and political expectations. “We believe the rebound in the real economy, corporate risk appetite, investment cycle and demand, will lag expectations,” he wrote, in an India strategy note. “This, combined with the ongoing political battles and impending general elections in 2014, is likely to make 2013 a noisy year. Simultaneously, more government action and an easing in macro pressures (inflation, interest rates) should support markets,” he said.

Another worry for the market is on bank asset quality. Goldman Sachs, an American brokerage, reckons it is not a big threat. “Banking balance sheet indicators are generally solid. The key risk is asset quality. We think that the latter will trough in FY13, and may improve gradually thereafter due to an economic recovery, better liquidity, and lower interest rates,” said Goldman Sachs, in a report.

But analysts at Kotak believe bank NPL is a big problem.

“We believe the widespread practice of restructuring and “ever greening” may result in potential problems in the Indian banking industry. In our view, the fallback option of such practices results in moral hazard issues and looser lending practices in parts of this industry. Also, such practices implicitly assume (1) a recovery in the economy and the financial condition of the stressed companies and/or (2) eventual recovery of the loans. In practice, banks have been quite lax about extending the “grace” period for bad loans. NPLs and restructured loans have risen to quite high levels over the past few quarters,” said Kotak.

Another concern for the market is whether the UPA government goes for a populist budget next month, ahead of the general elections in 2014. But, many now believe this may not be the case actually.

“We expect the government to present a market-friendly budget for FY14 (and may even try to contain social spending), with a clear roadmap for fiscal consolidation. This is important, in addition to the reforms process, to bring the economy back on track, and should ultimately give the government fiscal leeway for more social spending in late 2013, closer to the 2014 elections,” said Suresh A Mahadevan of UBS Investment Research, a foreign brokerage.

Abhay Laijawala of Deutsche Bank is sticking out his neck to say that the government will continue with the reform moves, and the chances of a populist budget are very low. “Our extensive meetings with New Delhi government officials have reinforced our belief that policy-making will be pragmatic, endeavouring to restore GDP growth to 7-8 per cent; this, and a capex cycle turnaround will form the hallmark of the policy end objectives. This will entail, in our view, difficult decisions that include subsidy rationalisation and accelerated decision-making. Since September last year, government action has been swift, suggesting an end to the paralysis, which has characterised Indian policymaking over the past two years. The forthcoming credit policy and the Union budget should be keenly watched for positive government intent on economic reforms,” he said, in a note.

Laijawala also see no major threat for India in the form of a spike in crude oil prices.

As far as the fisc is concerned, Kotak analysts believe India will have to change its approach to reduce the burgeoning fiscal deficit. “Instead of resorting to one-off revenues (sale of natural resources, divestment of stake in government-owned companies) to offset rising entitlements (subsidies and welfare payments), it may be better off reducing entitlements. Entitlements result in related problems of high inflation and higher costs of products and services,” the analysts said.

To sum up, the path ahead for Indian stocks looks bullish, except for the concerns highlighted above. The long-term strength of the market, and economy, will depend on how we tackle these challenges.

For the moment, it looks like the positives outweigh the negatives. zz